U.S. could face $2 trillion lending shock: Goldman

By IBT Staff Reporter On 11/16/07 AT 7:42 AM

The impact of the U.S. mortgage market crisis on the underlying economy could be dramatic as leveraged investors may need to scale back lending by up to $2 trillion, according to investment bank Goldman Sachs.

In a report dated November 15, Goldman's chief U.S. economist Jan Hatzius said a back-of-the-envelope estimate of credit losses on outstanding mortgages, based on past default experience, was around $400 billion.

But unlike stock market losses, which are typically absorbed by long-only investors, this mortgage-related hit is mostly borne by leveraged investors such as banks, broker-dealers, hedge funds and government-sponsored enterprises.

And leveraged investors react to losses by actively cutting back lending to keep capital ratios from falling -- A bank targeting a constant capital ratio of 10 percent, for example, would need to shrink its balance by $10 for every $1 in losses.

The macroeconomic consequences could be quite dramatic, Hatzius said in the note to clients. If leveraged investors see $200 billion of the $400 billion aggregate credit loss, they might need to scale back their lending by $2 trillion.

This is a large shock, he said, adding the number equates to 7 percent of total debt owed by U.S. non-financial sectors.

Hatzius said such a shock could produce a substantial recession if it occurred over one year, or a long period of sluggish growth if it occurred over two-to-four years.

One of a number of caveats outlined in the report was that baseline economic forecasts may already include significant reductions in the pace of mortgage lending.

But the conclusion remained a gloomy one regardless.

The likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized, he wrote. While the uncertainty is large, the associated downward pressure on lending raises the risk of significant weakness in economic activity.